krahe2_Christoph Reichweinpicture alliance via Getty Images_climateprotest Christoph Reichwein/picture alliance via Getty Images

Decarbonization Requires New Fiscal Rules

With its narrowly technical response to global warming, the European Union is steering the bloc toward fiscal shoals and social turmoil. Taking meaningful climate action requires an economy-wide approach, so that decarbonization is accompanied by good, high-wage jobs and financial security.

BERLIN – Climate policy is at a critical juncture. The world’s leading scientists see a rapidly closing window to avoid the worst ravages of global warming. With the enactment of the Inflation Reduction Act (IRA) last year, the United States has finally taken meaningful domestic action to reduce emissions. Now Europe is scrambling to respond.

But the narrowly technical approach prevailing in the European Union – and particularly in Germany, its biggest member state – is steering Europe toward fiscal shoals and social turmoil. To chart a safer, more sustainable course, climate policy must be linked up with broader economic and especially fiscal policy. In other words, meaningful climate action requires an economy-wide strategy.

To date, European governments have coalesced around an engineering response to fighting climate change. The European Commission’s Fit for 55 plan, for example, breaks down the problem into small, manageable pieces, creating targets for individual sectors and determining how much carbon reduction various solutions, taken in isolation, can achieve. The emerging response to the IRA turbocharges this paradigm, with faster planning procedures and more leeway for industrial subsidies, but does not change it.

This paradigm is not blind to social concerns. But here, too, a mindset favoring technical fixes prevails. To make carbon pricing palatable, introduce a carbon dividend. To address energy poverty, establish a means-tested monetary benefit. To assuage unemployment fears in the fossil-fuel industry, create a green-skills training program. The list goes on.

While filling an important gap, these policies are an eerie echo of the so-called Third Way espoused in the 1990s and early 2000s. Back then, voters were told not to worry about losing their jobs to automation and globalization. New and better opportunities were on the horizon. Workers could sign up for retraining programs, and welfare benefits would sustain them until they gained in-demand skills.

We know how that story ended. It turns out that well-paid jobs can disappear and be replaced by low-paid, insecure work. Entire regions can experience long-lasting decline, which is what happened in many advanced economies. Having lived through this, many workers voted accordingly.

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Climate policy must not fall into the same trap. The rising tide of decarbonization, like globalization and automation before it, will not automatically lift all boats. There is certainly no trade-off between prosperity and climate protection in the long term; we can only thrive on a healthy planet. But in the transition period, moving away from fossil fuels will increase costs and economic instability, owing to higher energy prices, temporary bottlenecks, shifting trade patterns, or financial instability.

Only a fundamental change of mindset can head off Third Way 2.0. Decarbonization must be accompanied by good jobs, high wages, and economic security, and no region can be left behind. An economy-wide problem requires linking climate policy with broader economic and fiscal policies. Focusing exclusively on emissions reduction misses the forest for the trees.

While a climate dividend may benefit low-income households, investing in education will likely lead to better jobs and higher wages across the board. Likewise, improving public-sector pay and employment conditions – which, compared to other EU countries, are relatively poor in Germany – will strengthen labor-market standards. And a resurgence of regional policy, building on EU programs like the Social Climate Fund or the older Cohesion Fund, may be needed to ensure that prosperity is distributed evenly within and across countries.

An economy-wide approach may seem unnecessarily complex, but there is no shortcut. Stopping climate change will require drastic shifts in human behavior and our economies. If these imperatives collide with widespread precarity, both people and governments can quickly be overwhelmed. This became apparent during last year’s cost-of-living crisis. Even in Germany, 40% of the population had no substantial savings to fall back on. When higher energy and food prices struck and inflation reached 3-4 times its normal level, the German government, like others in Europe, had no choice but to provide massive fiscal support.

One need not be a fiscal hawk to recognize that launching support packages of this magnitude whenever the climate transition hits a rocky patch is unsustainable. Preemptive action would be more efficient than relying on bailouts. Reducing economic fear and anxiety would also help to build majorities for an accelerated climate transition itself.

Achieving permanent full employment, good wages even at the bottom of the distribution, and hence economic security requires a new approach to fiscal rules. Short-term spending capacity is not the issue: fiscal rules in the EU have proven their flexibility in recent emergencies. Rather, at the European level, preemptive action requires overcoming the unhelpful obsession with national governments’ debt-to-GDP ratio. Instead, policymakers should focus on more relevant macroeconomic indicators like the primary fiscal balance (which excludes debt service), as well as more meaningful indicators of long-term prosperity, such as the zero-carbon readiness of the bloc’s assets.

In Germany, where the Schuldenbremse (debt brake) is constitutional, preemptive action could take the form of moving away from a largely backward-looking calculation of potential output and securing appropriate financing vehicles for municipal investments.

The goal, in other words, must be to reform fiscal rules and structures from the European to the municipal level, thereby ensuring suitable structural budgets for the next decade.

Finally, barring a return to pre-COVID secular stagnation, the aim cannot be simply to pour more money into the system. Instead, in addition to improving planning processes to accelerate supply-side adjustment, the tax system must be revamped to phase out fossil-fuel subsidies and manage any excess demand arising from an economy-wide approach.

Fighting climate change requires more than fast-tracking decarbonization and developing green technologies. It calls for linking climate policy to a bigger policy toolkit that enhances economic security. After the pandemic and more than a decade of anemic growth, too many people remain economically vulnerable. People everywhere require good jobs, higher incomes, and the ability to cushion shocks with their own savings – at least as a first line of defense. Climate activists marching with labor unions understand this. So does US President Joe Biden, who made headlines with the soundbite, “When I think climate, I think jobs.” It is high time for the EU to follow suit.

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